The relationship between interest rate policies and prices of crypto has been a hot topic. It is often disputed that there could even be a relationship because when you take market data over the past few years, you will find that crypto has on average no correlation with legacy markets.
If you take NASDAQ and BTCUSD on TradingView and look at them side by side (here’s how to do that), the picture looks different. It is beyond any doubt that there are at least periods of correlation between the legacy tech sector and crypto.
NASDAQ vs BTCUSD vs CIX on May 13, 2022
One possible reason for this is that institutional money is now the largest participant on the crypto markets. In their thinking, crypto is a close to a kind of tech stock, which is why their bots are programmed to trade it as such.
Looking at it from this angle, the FED rate hikes must have an impact on crypto as well as on stocks. (As a note, ECB’s interest rate policies as well, but to a lesser extent.)
Probably most accurate way to put it is that the opinion of US-based institutional traders on FED’s interest rates is what has impact.
But just for the reference, let’s first look at the basic theory of how do interest rates affect stocks and crypto.
Interest rates and stock or crypto markets
- Rule of thumb: FED rate hike makes markets go down. FED rate cut makes markets go up.
The Federal Reserve issues monetary policy with the following two aims: First is to manage inflation to protect people from undue rise in costs of living. The second is to keep unemployment low.
When the FED cuts interest rates, it means that borrowing money gets cheaper.
In theory, this should stimulate economy: People will be happy to spend, businesses will be happy to borrow and invest.
In practice, a common impact is that stock markets go up, because it is cheap to borrow money and speculate. This is said to bring about speculative bubbles.
When FED rises interest rates, it cools off the speculative bubbles because it becomes expensive to borrow money for speculations.
The true purpose of interest rate hikes is to manage inflation though. Central banks have their targets for inflation and once that gets out of hand, they are mandated to do something about it.
In the markets, higher interest rates can incentivize investors to sell any assets they perceive as risky. The reason for this behavior is that as it gets more expensive to borrow money, it is no longer rational to use that money to speculate on stocks because the returns on stocks are low.
By this logic, traders shouldn’t go and sell if the realistic returns on those investments were higher than the cost of borrowing money. On the stock market, high returns are not to be expected. They are not that rare in some of the high-tech stocks and they are absolutely not uncommon at all in crypto.
But even so, investor decisions after a rate hike typically end up lowering the prices overall because they create a risk-off environment.
Last rate hike to date: May 4, 2022
Here is the NASDAQ comparison again, with May 4th marked by the vertical line.
Last FED hike to date was on May 4, 2022. The FED hiked rates by half a percentage point to fight inflation. This was the biggest hike in two decades.
How did the market react? Stocks and crypto rose for a few days prior to the meeting and kept rising until the results of the meeting were out. Stocks leaped higher following the announcement, but topped out in the next days and turned into a downtrend.
As a rule of thumb, when the FED cuts interest rates, the stock market goes up. When the FED raises interest rates, it causes the stock market to go down.
The immediate price action in May 2022 was the opposite of the rule of thumb. Some explain it away by having the rate hike priced in. As a matter of fact, some traders expected the rate hike to be bigger). If the rate hike was smaller than expected, it could be read as a relatively good news and cause the markets go up.
Others explain that price action by the fact that it is not a good short entry if it doesn’t start at a local top. Also, eventually the long-term economic conditions are bound to prevail and show up in the price action.
Either way, there is no guarantee as to how the market will react to any given interest rate change, especially in the short term.
Some speculate two steps ahead
Reacting on interest rate is just speculation. It has something in common with technical analysis in that it can be a self-fulfilling prophecy: It is known that this is how traders react and so people try to front run each other.
Some traders also like to think two steps ahead, in a contrarian way. An analyst commented for MarketWatch that he believes this rate hiking cycle will be short. He thinks the FED will rise interest rates fast only so that they can cut them soon again. His opinion would have him start building a long position.
Social media likes this sentiment, including some of the crypto communities. A popular sentiment is to speculate that the last rate hike will increase unemployment figures, which would be a good reason for FED to start cutting rates again - especially in the current macro conditions.
Just for the record, the ECB president said on May 11th, 2022 that ECB will probably rise rates in July. ECB officials are concerned that the situation in Ukraine will keep inflation high, embed expectations of rising prices among consumers and companies and damage the economy.
Bottom line
The rule of thumb is that stocks go down as long as interest rates go up and crypto follows as long as the current correlation holds, which is not going to be forever. Even so, trading on interest rate changes is not a set-in-stone thing, especially not in the short term.